April 01, 2011

Paul Krugman on the Macroeconomics of Warren Harding

PK:

1921 and All That: Every once in a while I get comments and correspondence indicating that the right has found an unlikely economic hero: Warren Harding. The recovery from the 1920-21 recession supposedly demonstrates that deflation and hands-off monetary policy is the way to go.... But even a cursory examination of the available data suggests that 1921 has few useful lessons for the kind of slump we’re facing now.

Brad DeLong has recently written up a clearer version of a story I’ve been telling for a while (actually since before the 2008 crisis) — namely, that there’s a big difference between inflation-fighting recessions, in which the Fed squeezes to bring inflation down, then relaxes — and recessions brought on by overstretch in debt and investment. The former tend to be V-shaped, with a rapid recovery once the Fed relents; the latter tend to be slow, because it’s much harder to push private spending higher than to stop holding it down. And the 1920-21 recession was basically an inflation-fighting recession... a postwar bulge in prices, which was then reversed.... Money was tightened, then loosened again.... And so there was a V-shaped recovery:

The deflation may have helped by increasing the real money supply — at least Meltzer thinks so (pdf) — but if so, the key point was that the economy was nowhere near the zero lower bound, so there was plenty of room for the conventional monetary channel to work. All of this has zero relevance to an economy in our current situation, in which the recession was brought on by private overstretch, not tight money, and in which the zero lower bound is all too binding.

So do we have anything to learn from the macroeconomics of Warren Harding? No.

Let me just add that the economy was way underleveraged at the peak in 1920: the real value of all the debts in the economy had been written down by half because of the World War I-era inflation. Hence the normal channel by which deflation reduces business cash flow so they can no longer repay their debts and leads to bankruptcy which leads to panic which leads to deeper depression was not operating in 1921-1923.

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Paul Krugman on the Macroeconomics of Warren Harding

PK:

1921 and All That: Every once in a while I get comments and correspondence indicating that the right has found an unlikely economic hero: Warren Harding. The recovery from the 1920-21 recession supposedly demonstrates that deflation and hands-off monetary policy is the way to go.... But even a cursory examination of the available data suggests that 1921 has few useful lessons for the kind of slump we’re facing now.

Brad DeLong has recently written up a clearer version of a story I’ve been telling for a while (actually since before the 2008 crisis) — namely, that there’s a big difference between inflation-fighting recessions, in which the Fed squeezes to bring inflation down, then relaxes — and recessions brought on by overstretch in debt and investment. The former tend to be V-shaped, with a rapid recovery once the Fed relents; the latter tend to be slow, because it’s much harder to push private spending higher than to stop holding it down. And the 1920-21 recession was basically an inflation-fighting recession... a postwar bulge in prices, which was then reversed.... Money was tightened, then loosened again.... And so there was a V-shaped recovery:

The deflation may have helped by increasing the real money supply — at least Meltzer thinks so (pdf) — but if so, the key point was that the economy was nowhere near the zero lower bound, so there was plenty of room for the conventional monetary channel to work. All of this has zero relevance to an economy in our current situation, in which the recession was brought on by private overstretch, not tight money, and in which the zero lower bound is all too binding.

So do we have anything to learn from the macroeconomics of Warren Harding? No.

Let me just add that the economy was way underleveraged at the peak in 1920: the real value of all the debts in the economy had been written down by half because of the World War I-era inflation. Hence the normal channel by which deflation reduces business cash flow so they can no longer repay their debts and leads to bankruptcy which leads to panic which leads to deeper depression was not operating in 1921-1923.